Objectives and Instruments of Monetary Policy in An Islamic Economy

Objectives and instruments of Monetary policy in an Islamic
Economy:
The central bank has the responsibility to regulate the banking system and realize the
other objectives of monetary policy. Money serves as the medium of exchange and the
commonly-accepted means of payment. Excessive fluctuations in the value of money lead to
social inequalities. Inflation gives windfall gains to the rich and the business people but causes
hardship to the fixed and low-income groups by eroding their purchasing power. Deflation may
also aggravate recessions. The phenomena of inflation and deflation are characteristic of the
financial system based on the institution of interest which is prohibited in Islam.
1. Objectives of Monetary Policy in Islam

Consistent with the Islamic ideals of social justice, fairness and balance, there are three major
objectives of monetary policy in an Islamic economy which discards interest.
These objectives are:
a) Stability in the value of money
b) Economic well-being with full employment and optimum rate of economic growth
c) Distributive justice.
1.1 Stability in the Value of Money

In an Islamic economy it is almost mandatory on the central bank to preserve the value of money
because of the unequivocal stress of Islam on honesty and fairness in all human dealings.
1.2 Economic Growth and Employment

Monetary policy has to aim at a high rate of economic growth with full employment and
utilization of productive resources. However, maximization of economic growth at all costs is
not the objective of monetary policy in an Islamic economy. Material prosperity is to be attained
within the framework of Islamic values. It should not lead to an excessive and overly rapid use of
God-given resources at the expense of future generations.
1.3 Distributive Justice
Goal of distributive justice is to prevent concentration of wealth and economic power. Reduction
in income inequalities and necessary redistribution should be an important policy objective of an
Islamic state.
For this, it should use the instruments and methods that are not in conflict with the teachings of
the Islamic Shariah.
Theory and Practice of Interest-Free banking:
Sharia prohibits the payment or acceptance of interest fees for the lending and accepting of
money respectively, as well as investing in businesses that provide goods or services considered
contrary to its principles (Haraam).
The principle of profit-sharing and qard-hasanah offers the best alternative to interest in an
Islamic system. To charge interest from someone who is constrained to borrow to meet his
essential consumption requirements is considered an exploitative practice in Islam. Charging of
interest on loans taken for productive purposes is also prohibited because it is not an equitable
form of transaction. When money is invested in a productive undertaking the quantum of profits
that may accrue is not known before hand and there is also possibility of a loss. Justice demands
that provider of money capital should share the risk with the entrepreneur if he wishes to earn
profit. Under this system, the amount of return on the funds invested is neither fixed nor pre-
determined. When capital is provided entirely by one party and enterprise and/or labour entirely
by another party the profit is to be divided in proportions agreed at the time of the contract while
loss is to be borne by the provider of capital, unless it is due to the negligence of the
entrepreneur/worker. If there are more than one providers of capital, profit is to be distributed
among them in agreed proportions, while loss is to be shared by them strictly in proportion to
their capital contributions. Commercial banks would provide funds to business enterprises and
would be entitled to receive a part of the profits earned by the enterprise in accordance with the
agreed proportions stipulated in the mudarabah contract. As for deposits, the commitment on the
part of the bank to pay a fixed return on savings and time deposits would be replaced by an
agreement with the depositors to pay to them a part of the profits earned by the bank. The
amount of profit so arrived at would be divided between the shareholders of the banks and the
holders of savings and time deposits.
There are certain spheres where it will not be possible to use the system of profit/loss-sharing so
that use will have to be made of alternative devices to replace interest. Banking system should
provide loans to government on interest-free basis within the safe limits.
Under the Shari'ah, currency transactions are not treated differently from commodity transactions
in as far as lending and borrowing are concerned. The basic principle in this respect is that the
same quantity should be returned as was borrowed even though the price of the commodity may
have changed in the meantime.
If Muslim countries work jointly and promote movement of capital among themselves on the
basis of profit/loss-sharing or some other non-interest basis, it is not unlikely that, with the
passage of time, non-Muslim aid-giving countries and international financial institutions may
also begin to deal with Muslim countries on a basis compatible with Shari'ah. It has therefore
given qualified approval to certain other methods being used in conjunction with profit/loss-
sharing like leasing. However, cautioning against the danger that such methods could open a
back-door for interest, it emphasises that their use should be kept to the minimum extent that
may be unavoidably necessary under given conditions and that their use as general techniques of
financing must never be allowed.
In Pakistan, interest had been eliminated from the operations of a number of specialised financial
institutions and more than 6500 branches of Pakistani banks had just embarked on interest-free
banking by opening separate counters where people could deposit their savings which banks
undertook to invest in profitable but interest-free avenues. They accept both current deposits and
deposits committed for investment which are called Investment Accounts. The Investment
Accounts are usually of two types, namely, accounts with authorisation and accounts without
authorisation. In the accounts*with authorisation, the account holder authorises the banks to
invest the money in any project. In the other type, the account holder may choose any particular
project for investment of his deposited money. On the assets side, these banks were found to be
operating on the basis of musharikah and mudarabah which are essentially profit-sharing
arrangements. Besides, business is conducted on the basis of murabaha under which the bank
buys a specified item for the client who agrees to pay the bank later, in lump sum or instalments,
a price including an agreed percentage of profit. Persons holding investment accounts in these
interest-free banks are reported to have received a return ranging from 8 to 15 per cent which is
again comparable to rates of return available in interest-based banks.

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Objectives and instruments of Monetary policy in an Islamic

1. Objectives of Monetary Policy in Islam

1.1 Stability in the Value of Money

1.2 Economic Growth and Employment

1.3 Distributive Justice

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